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Tyler Durden, "Fight Club" (1999) Punta del Este | Last week our comrade at Zero Hedge astutely noted that, in the October 2012 FOMC minutes , Fed governor and soon to be Chairman Jerome Powell opined that the Fed has a “short” position in volatility. Powell said: “[W]hen it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.” Of course, none of the economistas who supposedly follow the Fed for a living actually noticed Governor Powell's honest comments about how unwinding a short position in volatility might impact the markets. As we noted at the end of last year (“ Banks and the Fed’s Duration Trap ”), the Fed’s open market purchases of securities or “QE” has taken trillions of dollars in bonds out of the market, effectively reducing the amount of securities or duration available to private investors. The Fed’s $4 trillion or so in Treasury securities and mortgage backed securities (MBS) is not hedged, thus the Fed is long duration and has capped volatility in the markets as a result. Securities trading volumes by banks are also lower as a consequence of QE, hurting bank earnings. Most large banks have guided down trading revenue for Q4 ’17. But when Powell said that the Fed would “sell” $20 billion per month, he actually misspoke. The Fed is not going to actually sell any securities. And is his comment about the Fed having a “short volatility” position correct? We think not. Mark Dow on Twitter noted: "Being long MBS you are implicitly short treasury volatility. This is what Powell meant. The tinfoil hat charlatans left it ambiguous so that their readers would infer all kinds of nefarious direct manipulation of the VIX." Volatility is commonly viewed as a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or a market index such as the S&P 500. But like measuring "liquidity," trying to quantify forward price movements of a security based upon past data is a fool's errand. Students of Dow theory know that the past tells you nothing about the future. Yet since the Fed has suppressed interest rates and credit spreads through purchases of Treasury debt and MBS, is the central bank really “short” volatility? No. The Fed is certainly long duration, which is why the Federal Open Market Committee will not actually be selling any securities from the portfolio. Instead, as we discussed with Bob Eisenbeis of Cumberland Advisors in December , the FOMC intends to merely end its reinvestment of cash when securities are redeemed. That’s it, no outright bond sales. So is the Fed short volatility? No, but that is the joke on all of us. Thanks to the Fed’s manipulation of the credit markets, we are all short-volatility. The mostly commonly discussed measure of volatility is the VIX contract traded on the Chicago Board Options Exchange (CBOE). Unlike measures of actual market volatility, the VIX is a popularity contest; the measure of expected future volatility which is generally calculated as 100 times the square root of the expected 30-day variance or value at risk (VaR) of the S&P 500’s rate of return. By holding down bond yields and, indirectly, compressing credit spreads, the FOMC has reduced actual volatility and, more important, also gradually reduced the market’s expectations for future movements in the prices of securities. Chart 1 below shows the VIX over the past five years along with the spread between the 10-year Treasury bond less the 2-year Treasury note. Observe that as the Fed prepares to end bond purchases, the VIX has reached all-time lows. Expectations, after all, are a lagging indicator. Former Fed Chairman Ben Bernanke has argued that the FOMC should not begin to shrink its balance sheet until short-term interest rates are well away from their effective “lower bound,” one the magical terms employed by economists to convey the impression to the public that they know what they are doing when it comes to financial markets. Yet as we and a growing number of investors seems to appreciate, the Fed cannot force up long term rates so long as it is sitting on $4 trillion worth of securities that it does not hedge. More, given that the Treasury intends to concentrate future debt issuance on short-term maturities, downward pressure on long-term bond yields is likely to intensify, as Eisenbeis observes in his most recent comment on the FOMC minutes . What the FOMC has done to the markets via QE is essentially reduce potential volatility by holding securities and not hedging these exposures. The European Central Bank and Bank of Japan (and all global; central banks) do the same by purchasing securities and not hedging against price movements. In normal times (whatever that is), central bank purchases were so small relative to the markets that actual volatility served as a good indicator of future risk. But today, in the induced coma known as QE, measures of volatility are suppressed along with bond yields. Thus ZH asks the obvious question: How does Powell feel about volatility today? Dan writes: “Maybe someone can ask Powell at the next FOMC press conference just where that stands today, and whether he is still as skeptical the Fed will succeed in unwinding its balance sheet, as he was in October 2012.” ZH also quotes Powell on the risks of ending QE: “My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.” Yes, markets can be dynamic when they are allowed to operate. The whole point of QE has been to prevent the normal operation of the financial markets. As we all know, the social engineers on the staff of the Federal Reserve Board in Washington have a huge God complex . The Fed’s gnomes think they can manipulate markets with no downside risks. But they also fear taking losses on the Fed’s portfolio for fear that it will awaken critics of the central bank in Congress. So while the Fed is certainly long duration, we dear friends are short volatility thanks to QE. Or as Grant’s Interest Rate Observer said so well: “The Fed is selling, you are buying.” As the Fed ends its reinvestment of cash when bonds redeem, volatility will return to the markets, spreads will widen and trading by private investors will rebound. A lot of market participants will get their eyeballs ripped out when the weight of option-adjusted duration shifts back to private investors. Can't wait. "What everyone is missing is that as the US Treasury and MBS holdings roll off, the duration of their overall holdings is hardly affected," notes industry veteran Alan Boyce, referring to the possible extension of the MBS. "It is the higher coupon MBS plus the 15 year paper that are going to prepay. The new Fannie Mae 3s are not going anywhere. On the US Treasury side, ZERO of the long bonds are going away, they will just slowly March down the yield curve over the next 30 years. Amazing but true, the FOMC's taper could result in longer aggregate effective duration of System holdings even though the footings shrink." The return of market function, however, will spell bad news for the Fed’s MBS portfolio, which will decline in price faster than the market thanks to the convexity of mortgage securities. But as Boyce notes, the portfolio will also extend in duration as prepayments slow. This is just one reason why we don’t expect Chairman Powell to have a lot to say about volatility in future utterances. Fed Chair Janet Yellen and the majority of the FOMC have created a trap for themselves and Powell get’s to clean up the mess. The FOMC cannot sell securities without creating losses for the System Open Market account, thus triggering criticism from the Republican majority in Congress. But they cannot hike short-term interest rates three more times in 2018 as currently planned without inverting the Treasury yield curve and provoking fears of a recession. In order to manage the normalization of interest rates, the Fed ought to be selling the bonds and MBS, TBAs and dollar swaps to force long-term yields higher and thereby maintain a relatively normal curve. Hell, the Fed could even buy some mortgage servicing rights or MSRs as a hedge against its MBS. But that would require imagination and courage. A flat curve will be bad for financials, which are already facing an earnings bloodbath in Q4 ’17 thanks to reduction in corporate tax rates (and a commensurate mark-down in the value of tax loss carry forwards). Lower trading volumes will likely also be a negative for bank earnings this quarter. And lending volumes in just about every bank asset class are also soft, begging the question as to when big bank equity valuations will reset. More important for Chairman Powell, a flat yield curve will demonstrate to the markets and Congress that the majority on the FOMC has not the slightest idea how their policy moves impact the real world of money and credit. Powell certainly seems to get the joke. His first challenge as Fed Chairman may be navigating the dangerous political mess created by Chairman Bernanke and Chair Yellen, who actually seem to think that the US bond market can endure several years of an inverted yield curve as we wait for the Fed’s portfolio to run off before the central bank completes the normalization of policy. #zerohedge #VIX #JeromePowell #Bernanke #Yellen #TylerDurden

Justice Louis D. Brandeis Time Magazine, July 7, 1930 This week in The Institutional Risk Analyst, we feature a blog post by Christopher Whalen originally published by The National Interest that tries to explain the false narrative about lower corporate taxes resulting in the repatriation of trillions in offshore cash. Many economists have spent months waxing ecstatic about the potential investment surge that will result, but sad to say it ain't so. We'll be following up with a more technical discussion of variable interest entities (VIEs) and tax fraud in a future post for The IRA. Till then, as you enjoy this week's comment, ponder the fact that not all VIEs are used for tax avoidance, but no VIE can really ever be a "true sale" that meets the draconian test established in 1925 by the U.S. Supreme Court. As Justice Louis Brandeis wrote in Benedict v. Ratner, an incomplete sale "imputes fraud conclusively." Suffice to say that the Internal Revenue Service gets the joke. Punta del Este | When the founders of the United States framed the US Constitution, one of the concerns that guided their work was the knowledge that popular democracy would eventually become an entirely commercial proposition. This fear is clearly illustrated by the tax “reform” legislation just passed by the Republican majority in Congress. It seeks to buy votes next November with reductions in federal tax revenue that must ultimately be funded with ever larger amounts of public debt. Of course, all of us hope that the various provisions of the tax bill will in fact lead to more investment, higher productivity and increased economic growth. Yet if we examine the narrative that helped to win passage of the legislation, many of the assertions made by politicians and their allies in the world of economics make little sense. In particular, the notion that lower corporate tax rates will lead to repatriation of corporate cash stashed offshore, thereby funding increased investment and productivity, and ultimately crating more jobs in the US is, upon reflection, a complete nonsense. First and foremost, corporate investment decisions are based upon the cost of capital and the prospective equity returns that new investment can generate, not the availability of cash. In a world where corporate bond yields are at all time lows and equity market valuations are at all-time highs, the effective cost of capital for many multinational companies is arguably negative. The problem is not funding new investments, but finding new endeavors in which to deploy cheap and plentiful capital. The economists who largely control the major central banks in the industrialized nations may be able to manipulate markets and cancel excessive debt through open market operations, but they cannot manufacture attractive investments. Indeed, the low interest rate regime put in place by the Federal Reserve, European Central Bank and Bank of Japan arguably retards new productive investments by driving cash into real estate, commodities and speculative whimsies such as crypto currencies. One of the most outrageous fallacies put forward by economists over the past year is that lower US corporate tax rates will cause the repatriation of offshore cash balances. This view, which is widely endorsed by many analysts, fails to reflect the true nature of offshore tax schemes and how problematic it will be to reverse these complex transactions. In 2016, Karen C. Burke and Grayson M.P. McCouch the University of Florida published an article entitled “Sham Partnerships and Equivocal Transactions” for the American Bar Association’s journal Tax Lawyer . The understated article provides an in-depth look at how US corporations have stashed literally trillions of dollars in offshore venues since the 1990s to avoid domestic taxes. The authors state: “Corporate tax shelters proliferated during the 1990s, exploiting the flexible partnership tax rules of Subchapter K to defer or eliminate tax on hundreds of billions of dollars of corporate income. The corporate tax shelters were typically structured as a financing transaction in which a U.S. corporation leased its own assets back from a partnership, generating a stream of deductible business expenses while shifting taxable income to a tax-indifferent party such as a foreign bank. Since the transaction allowed the U.S. corporation to raise capital in a tax-advantaged manner in connection with its regular business operations, it was assumed that the transaction had economic substance. Nevertheless, in scrutinizing these shelters, courts have invoked a sham partnership doctrine, derived from the longstanding Culbertson intent test, which disregards a partnership that lacks a bona fide purpose (or, alternatively, a purported partner whose interest does not constitute a bona fide equity participation).” The Internal Revenue Service is on to these fraudulent scams for which, of note, there is no statute of limitations. Significantly, in January of 2017, the US Supreme Court declined to hear an appeal involving an adverse tax decision by the IRS against an affiliate of Dow Chemical known as Chemtech. The hundreds of corporations that have used offshore transactions to hide revenue knew that Dow’s appeal was their last hope to avoid sanctions by the IRS. General Electric is another example of a US corporation that has been forced by the IRS to reverse a bogus offshore “asset sale” transactions. The IRS process of disallowing sham offshore transactions can be catastrophic. Consider the 2012 bankruptcy of tanker operator Overseas Shipholding Group (OSG). When the IRS disallowed half a billion dollars in offshore “asset sale” transactions, the company was forced to file bankruptcy and restate years of financial statements. A torrent of litigation ensued. Violations of US tax laws can lead to both civil fines and criminal prosecution for the corporate managers and their legal counsel who designed these schemes. In the case of OSG, the company’s tax counsel was sued for negligence in the bankruptcy. OSG’s tax lawyers then sued OSG’s senior executives. The competing claims were eventually settled, but none of this has created any value for OSG’s shareholders much less any new jobs. The 2017 tax law begins a new regime for future corporate taxes, but it may also compel recognition of huge past-due tax liabilities. All previous offshore corporate tax avoidance scams will now be exposed to IRS review. Dow and General Electric were required to pay back taxes, interest and penalties (up to 60% in Dow’s case). Dow and General Electric, however, escaped the criminal prosecution other corporate managers (and their legal counsel who designed these schemes) have faced. The process of reconciling offshore revenues is going to be exceeding painful for corporate managers and investors alike. Fessing up to past acts of tax avoidance is hardly likely to result in a wave of new corporate investments that increase productivity and economic growth. Indeed, while the process of coming to Jesus in the world of offshore financial partnership may generate a lot of revenue for the US Treasury, it is unlikely to boost corporate investments or even result in the actual return of cash to the US. Some investors are already anticipating that the tax legislation will result in a bonanza of stock repurchases that will boost share prices above current levels, but in fact the opposite may be the case. With an appropriate level of enforcement by the IRS, the notion that a lower tax rate on future revenue will lead to increased levels of cash for US corporations that are compelled to come forward and confess their sins with respect to past tax returns and financial disclosure seems fanciful. Many economists will be surprised to learn that the new tax bill does not actually require repatriation of offshore cash. Treasury is instead employing "deemed repatriation," which means the IRS taxes you on your unrepatriated foreign earnings whether you bring the cash back to the US or not. Taxes will be applied over eight years in an end-weighted formula which means you make your biggest payment, roughly 25% of taxes due, in year eight. The tax rates reportedly will be 15.5% on cash balances and 8% on non-cash balances. Just imagine what a compliance nightmare this creates. What is the definition of "cash"? More astute corporate managers and legal counsel who have participated in past tax avoidance transactions may approach the IRS and try to cut a deal. We could even see a formal tax amnesty proposed by the Trump Administration, but Washington insiders give such an idea long odds in the near term. “Treasury would consider offering an amnesty only if corporations evinced a real fear that they were about to be caught up in its maw,” notes one respected tax analyst in Washington. “I’m not 100% sure we are there yet. We did this with Swiss bank accounts only when we had them dead to rights.” Treasury is already working on the implementing regulations for this “virtual repatriation.” Another veteran Washington observer says that earnings return provisions of the tax bill are the highest priority item, followed by the anti-base erosion provisions, and then the worldwide regime on Global Intangible Low Tax Income--with a great acronym, “GILTI.” In theory, Treasury is going to put in place the deemed repatriation rule to raise the roughly $200 billion over ten years they need to move to a system which excludes most foreign-sourced active business income from U.S. taxation. This is the aptly named “participation-exemption system” that the US business community has been lobbying to get for years. But of course none of this is likely to result in a wave of new investments or job creation – unless you are a tax lawyer or consultant. One way or another, Treasury is going to collect its money. Perhaps that’s how House Speaker Paul Ryan plans to cover the increased deficits intentionally implemented by the new tax legislation. And for all of you economists and hedge fund moguls who think that the new tax legislation will result in a cash repatriation bonanza that will benefit stock prices or the economy, better think again. #deemedrepatriation #taxfraud #Brandeis #truesale #variableinterestentities #GILTI #taxes #corporatetaxes #OverseasShipholdingGroup #DowChemtech #GE

To read our post in The American Conservative on the growing bitcoin fraud, see the link at the end of this issue. Happy holidays! The US housing market is completing another year of rising home prices in many – but not all – parts of the country. We’ve been in a sellers market for single family homes since 2012, fueled first by low prices, then by low interest rates, then lower FHA premiums, and also the relative dearth of new home construction. So with interest rates slowly normalizing and significant changes to the tax code, what does the future hold in store for housing finance? For the past eight years, the FOMC has been boosting housing with low interest rates and purchases of MBS. More, for the past half century, public policy in the US has encouraged home ownership with a variety of subsidies and tax breaks. Now, however, Congress is turning the thrust of public policy away from encouraging home ownership in a way that could have serious negative implications for an important part of the US economy. Chart 1 below shows the Case-Shiller home price index since 2007. As the tax legislation takes effect, a number of observers are predicting that high-cost markets on the east and west coasts could see prices fall by double digits – this despite the continued squeeze on supply. Over the longer term, notes Jonathan Miller of Miller Samuel, the loss of deductions for state taxes and mortgage interest will put downward pressure on prices in high cost markets. Think Scarsdale NY. Elimination of mortgage deductions for second homes and home equity lines also will negatively impact affluent destination markets around the US. The impending tax reform legislation in Washington could not only mark a significant change in the price dynamic for home prices, but it may also signal a negative credit trend for investors in 1-4 family mortgages. As households are forced to pay out more cash for federal taxes and mortgage payments, there will be less remaining cash flow in these households overall. Price compression will also affect perceived wealth and also aspirational pricing. But the big question is how the tax bill will impact overall volumes for home purchases and new mortgages. The latest data from The Mortgage Bankers Association shown in Chart 2 shows a slight uptick in mortgage lending volumes for Q3 and Q4 2017, a welcome bit of good news for the industry after the single-digit profitability seen in the first half. Even today, lending profitability spreads are running a tad under a quarter of 2007 levels, putting intense pressure on non-bank lenders especially. Source: MBA The good news is that the MBA estimates show total mortgage debt volumes growing 10% to $11 trillion by 2019, this due to expectations of rising interest rates and lengthening durations on mortgage-backed securities (MBS). Purchase mortgages are expected to grow steadily while refinance transactions are flat-lined at around $100 billion per quarter in the MBA estimates. More than a little of that increase in total mortgage debt, however, comes in the form of rising home prices and mortgage balances. Of the 1.7 million loans originated in Q4 2016, the average of the $461 billion in originations was about $275,000 per loan. Of note, the average size of purchases mortgages is now around $310,000 vs $260,000 for a mortgage refinancing, as shown in Chart 3. Source: MBA The big question near-term is whether all of the talk about higher interest rates will actually result in higher yields for the benchmark 10-year Treasury bond. In the wake of the latest rate hike by the Federal Open Market Committee, spreads actually tightened. We continue to believe that the size of central bank portfolios globally means low volatility and no significant selling pressure on long-dated government debt in 2018. Even if the FOMC were to take our advice and start selling MBS outright, we don’t believe that long rates would rise very much if at all. As we noted last week in our conversation with Bob Eisenbeis of Cumberland Advisors , the FOMC is more worried about losing money on the Fed’s portfolio than it is about the impact of QE on the bond markets. The result will be a flat yield curve and spread compression for leveraged investors such as banks and REITs. But the forward Treasury issuance calendar suggests at least some upward pressure on rates in the medium terms, as mortgage finance maven Rob Chrisman opines: “Foreign central banks that use Treasuries to manage currency exchange rates are not facing the market forces that would require a return to the amount of accumulation seen over the last decade. As a result, the private domestic and foreign sectors would be left as a principle buyer of Treasuries. Baring another financial crisis, it is unlikely that a significant increase in demand for safe-haven assets is on the horizon. If demand for Treasury debt does not keep up with the expected increase in supply, yields will need to rise.” We think that the supply/demand scenario in US Treasury bonds becomes an issue, ironically, when the Fed accelerates its planned asset reduction and thereby allows volatility and volume to return to the trading markets. The FOMC ought to be concerned with restoring something like normal function in the bond markets after years of induced monetary coma, even if it means taking a loss on the system portfolio. It will be interesting to see how Chairman Powell deals with this sticky political issue of losses on the Fed’s huge securities book, particularly in an environment where the FOMC continues to raise short-term rates. Historically, the 10-year Treasury has floated about 2% above inflation, but as Jim Glassman at JPMorgan ("JPM") noted in June: “The slump in Treasury yields is almost entirely due to quantitative easing distorting the ‘real’ component of interest rates.” Ditto. The FOMC currently has Fed funds targeted at 1.5% and hopes to move this benchmark rate to 2.75% over the next couple of years. With statistical measures of inflation still at or below the 2% target for prices, this suggests a 10-year bond closer to 3% than to 4% -- at least in normal circumstances. But with global central banks still sitting on $20 trillion in securities and still buying, market conditions are hardly normal. Central bank positions in US Treasury and MBS suppress both volatility and trading volumes, reducing upward pressure on long-term yields. We believe that one of the better trades for 2018 may be a long position in the 10-year Treasury with a short on the 2-year Treasury note! Looking at estimates from the MBA and other economic estimates, the consensus seems to have the Fed funds rate hitting 2 ½% by 2019 and the 10-year over 3%. We wonder, however, if the continued purchases by the ECB and Bank of Japan, and the go-slow policy of crawling normalization adopted by the Fed, won’t keep an effective cap on long-term interest rates. We see the possibility of a rally in the 10-year in 2018 with tighter spreads and an inverted yield curve, a turnabout that could have an interesting impact on housing finance. The tight spread regime engineered by the Fed and other central banks has negatively impacted all manner of consumer lenders, with effective loan pricing near all-time lows. Large banks fight for jumbo prime mortgages at pricing that makes no sense – but they simply want the assets. The same pricing logic governs credit spreads in auto paper or commercial real estate and other types of business lending. The fact that most of the major investment banks have guided down, again, on trading revenues reflects the fact that QE and low rates have sucked the life out of the private financial markets. With most global asset classes still largely correlated, predicting what happens out beyond 2019 becomes real guesswork. Until the Fed and other central banks agree to stop accumulating securities, the private markets measured by volatility or volume or trading profits will suffer accordingly. How is this helpful? Final thought on housing. One other impact of the tax reform legislation is that the reduction in corporate tax rates will cause a proportional reduction in the value of tax loss assets to shelter future revenue. Citigroup ("C") will reportedly write-down $16 billion alone, but will still have plenty of accumulated losses to shelter income for years to come. And the erstwhile GSEs, Fannie Mae and Freddie Mac, will likewise need to write down capital to reduce the value of tax loss assets. In the event, both GSEs are likely to need additional capital draws from the US Treasury. We wonder if the Trump Administration will use the fact of the additional advances to the GSEs as a legal pretext to put both of the entities into receivership. Without new legislation, the only way to end the conservatorship of the GSEs is to put them through a formal receivership process. While for many in the housing industry restructuring the GSEs is truly thinking the unthinkable to borrow the title of Herman Kahn’s classic book, “On Thermonuclear War”, receivership has been discussed as a policy option at the White House and would be supported by many Republicans. In the event President Donald Trump decides that housing finance may provide some political leverage, all of the comfortable assumptions about mortgage production or credit spreads or even interest rates will fall by the wayside. Next year is an election year, after all, and tax cuts and reforming the GSEs makes for good conservative political fodder. Bitcoin: The Most Impressive Speculative Bubble In Modern History The American Conservative #bitcoin #blockchain #bitcoinfraud #GSEs #HousingFinance #spreads #mortgage #MSR #mortgagebankersassociation #MBA

In this issue of The Institutional Risk Analyst , let’s first ponder last week’s revelations that the European Central Bank is taking a loss on its purchase of bonds issued by Steinhoff International, the high flying (and highly levered) South African-based home retailer that was struck down by an accounting fraud scandal. This event illustrates how central banks have distorted the credit markets and allowed inferior borrowers access credit at investment grade spreads. This notion of central bankers booking trading losses on their extraordinary open market intervention over the past decade is important because it provides context to understand their decision making. For example, based on our conversation last week with Bob Eisenbeis, Cumberland Advisors’ Vice Chairman and Chief Monetary Economist, we’re pretty certain that the Federal Open Market Committee will further flatten or even invert the Treasury yield curve in 2018 and for reasons that will astound and amaze many investors. Going back as early as 2010 (“ MBS – WHEN WILL THE PURCHASES END AND WHAT WILL HAPPEN TO MORTGAGE RATES? ”), Bob has been writing timely analysis for Cumberland describing the dynamics of the Fed’s large scale asset purchases, euphemistically known as “quantitative easing,” and what would happen to the bond markets once QE ended. Now that the end of QE is in sight, we ask Bob if the return to normal will be as “beautiful” as Mohamed A. El-Erian suggests in his effusive Bloomberg commentary . The IRA: Thanks for speaking with us Bob. We wanted to talk a bit about your recent comment on Marvin Goodfriend’s nomination to the Fed Board but also talk about your broader view of the normalization process. You may have seen Mohamed A. El-Erian’s fulsome public praise for the FOMC’s policy direction. We’ve always been of the view that the Fed should have stopped after QE1. How do you see it? Eisenbeis: When you look at the research on QE, the opinions are all over the map both inside and outside of the Fed. I think there is a consensus that there were diminishing returns in the additional QEs that were engaged in after QE1. Then it’s a question of what are the costs and benefits of getting out of the program. Those who suggest that QE has been a huge success are premature in my view. You don’t really know until we are completely out. It looks to me like we are going to be OK on balance, but what really bothers me is this constant drum beat inside the Fed and by some outsiders about the huge “profit” earned from QE. They have the accounting all wrong. The IRA: Well, the board is aligning itself with the idiocy on Capitol Hill, where the interest earned by the Fed is viewed as “income” for budget purposes. Most members have not read your 2016 testimony on the Fed's fiscal relationship with Treasury . But Bob, really, is it possible that PhD economists don’t understand the financial relationship between the Treasury and the central bank? We always like to remind people that the US Treasury issued the original $150 million in greenbacks directly into the market to help Abraham Lincoln fund the Civil War. The Fed is the Treasury’s alter ego and is an expense to the government, which is subtracted from the earnings on the portfolio and then returned to the Treasury. Eisenbeis: Correct. The Fed almost by definition cannot make a profit. It baffles me how people inside the system can fail to see the accounting reality here. The Fed issues short term liabilities to buy Treasuries taking duration out of the market. The Treasury makes interest payments to the Fed who takes out its operating costs, including interest payments on reserves and returns the remainder to the Treasury. If this intra governmental transfer were settled on a net basis like interest rate swaps, there would always be a net payment from the Treasury to the Fed. It is too obvious, yet I am not privy to the sidebar conversations on this issue. But back to the point on QE, if the Committee can run off the portfolio through attrition, then they’ll probably escape any need for additional action barring some unforeseen change in the economy. The current path for growth and employment in the third quarter seems pretty positive. The IRA: Does the FOMC understand how their actions and the actions of the ECB, Bank of Japan, etc has not only pushed down the price of credit, but has suppressed volatility since these positions are not hedged? Just as with the Volcker Rule and bank investment portfolios, there is no trading around Treasury and mortgage backed securities (MBS) positions held by central banks. As we told CNBC , " Financial sector on fundamental basis is considerably overvalued ," it's no surprise to see Citigroup (C) and other banks guiding the Street lower on trading results for the year. The dearth of duration and trading volumes is a direct result of QE, correct? Eisenbeis: The volatility impact of QE is not something that was on anybody’s radar screen at the time to my knowledge. The bigger concern was that the longer you keep rates low, you start to get dislocations that take place in various markets. Everybody is looking for a bubble here or a bubble there, but the only place you can really argue a bubble exists is in the stock market. But that is really the concern, not the volatility issue or the impact on the markets. The IRA: That suggests a remarkably linear view of the bond market on the part of the Fed. In the $1.7 trillion MBS portfolio, the Fed has sequestered a huge amount of duration extension risk. If prepayments fall due to rising rates, the effective maturity of the security extends and the price of MBS can fall faster than that for benchmark Treasuries. But nobody is hedging the Fed or ECB or BOJ or Bank of China holdings of MBS. As a result, we seem to be headed for a flat or even inverted yield curve environment and with flatlined volatility. Do the folks at the Board understand what the combination of passive central bank portfolios and falling trading volumes is having on large bank earnings? Eisenbeis: If you would see anybody in the system focused on this question it would be the Fed of New York. You mentioned the May 2014 FRBNY blog post on convexity of MBS in your comment earlier . I haven’t seen anything in the FOMC minutes suggesting that Bill Dudley raised the volatility issue during his tenure. But I think the Fed is going to go very cautiously on rates for reasons you suggest. With a new Chairman and governors, you might think there would be room for some change, but in fact they are going to go very slowly. The Fed staff is going to describe to the new governors why certain things were done and under what circumstances. The IRA: So you don’t see a lot of change in policy under Chairman Powell? Eisenbeis: Not a chance. He and the new governors are going to move slowly in terms of any change in direction. They are looking for a community banker for the Board and that person will also tend to be cautious. And the appointment process in the Senate is likely to be slow and contentious. Marvin Goodfriend is too experienced to come onto the FOMC and start rocking the boat. The four bank presidents who are economists and voting on policy in 2018– Bostic, Dudley, Mester and Williams -- are all very solid and experienced, so I’d look for a pretty slow and steady process from the Fed. Some of the governors (Powell and Quarles) and presidents, who will be FOMC participants this year, are not economists, which has a big impact on the policy process from a research perspective. The IRA: Well, back to the market, the folks at the Fed who brag about making money on QE are about to let the markets take the risk on a bunch of FNMA 3s and 3.5s that contain a lot of duration extension risk. As this paper is held by private investors, the positions will be hedged and volumes and volatility should be restored or not? Eisenbeis: What that will do is essentially put upward pressure on rates. This would moderate the need to make policy changes. We published a comment on the runoff of the Fed’s portfolio and when it would come into “equilibrium” so to speak in terms of size. There is no coincidence that MBS on the System Account are paying down about $20 billion per month and the Fed has chosen $20 billion threshold number for monthly portfolio reductions. We estimate that according to the Fed’s plan, the portfolio necessary to restore the currency-to-GDP ratio to its pre-crisis level, would be about $1.9 trillion and normal runoff would achieve this objective in the fall of 2023. Just from a runoff perspective, though, the impact on the markets is not going to depend so much on the Fed as on the Treasury as their issuance needs increase. The Fed is going to reinvest portfolio maturities across the yield curve in proportion to the Treasury issuance. The IRA: Well, precisely. This goes back to the earlier point about profitability. The Fed and the Treasury are one and the same. Different faces of a Hindu deity. Eisenbeis: But this is precisely why these MBS cannot be sold. The IRA: Is this an institutional issue for the Fed? Are they avoiding sales of MBS to avoid taking a loss on the portfolio and thereby eroding the need for chest thumping about the profitability of QE? Eisenbeis: I think that is a good bit of it. If you recall, the Treasury robbed the Fed’s capital a few years back to fund spending for a highway bill. There’s a cap now on Fed equity at $40 billion. And the Fed cut a deal with Treasury that if the Fed takes a loss on the sale of assets they don’t have to write it off against capital. They create a “negative asset” account. What is that? You can do the math and see that the bank’s net worth may be negative. The IRA: It’s like a net operating loss for a central banker. But Bob are you suggesting that the Fed is more worried about the possibility of embarrassment over taking a loss on the sale of MBS than they are about the impact of policy on the financial markets? Even to the extent of seeing a negative yield curve in the Treasury market? How can we do three hikes in 2018 and not have an inverted curve? Eisenbeis: Substantively as we’ve discussed, it is the Treasury that backs everything up. But it’s the optics that matter. The optics of the Fed losing money or being insolvent are bad, both in Washington or around the world. Thus they will run off the MBS naturally via prepayments to the extent possible and avoid losses on sales. More important, though, it is very clear that we will have a flat yield curve both on the long end with continued demand and on the short end with the Fed raising benchmark rates. But all of this means that the Fed will go slow. The IRA: Thanks Bob #eisenbeis #cumberlandadvisors #duration #FOMC #spreads #QE

Palm Beach | We think 2017 will be remembered as the Year of the Bubbles. Everywhere you look, whether its stocks or real estate or even overt acts of fraud like bitcoin, the value of fiat paper dollars measured in prices for other “assets” is falling. Crypto currencies, to be clear, are more a class of felony than investable assets, but the crypto games provide supply for demand in an age of scarcity engineered by the central banks. During a visit to the Atlanta Fed last week, we had a fascinating dinner with a group of institutional investors. Like many metros around the US, Atlanta real estate is booming after years of post-crisis lethargy and ample amounts of monetary gasoline from the FOMC. Our friend Dick Hardy organized the dinner. He noted, going back to crypto, that bitcoin is really about a shrinking float of available tokens, an ingenious aspect of the bitcoin scheme. But in the world of bank credit, scarcity and abundance exist simultaneously. Bank earnings in 2018 are likely to continue to rise with asset returns, and expenses are likely to fall as regulatory changes ripple through the world of banks and non-banks alike. The big wild cards are an inverted yield curve in the US and an economic slowdown in China, as we discussed in our interview with Lee Miller of China Beige Book . But in terms of valuations for financials, current equity and asset returns for US banks remain significantly below pre-crisis levels. Chart 1 below shows asset and equity returns for all US banks. Source: FDIC For the past five years, there has been a bull market in residential and commercial real estate, albeit for properties that are decidedly up-market. With the increased cost of regulation, the minimum threshold for a residential mortgage that somebody actually wants to service has risen proportionately. If the mortgage has a unpaid principal balance of say $300k or less, it is just marginally profitable for many servicers – especially those located in CA. We note in this regard that Walter Investment Corp (WAC) just filed for bankruptcy court protection. Other non-bank players in the residential mortgage space are struggling. During our discussion last week in Atlanta, MBA chief economist Mike Fratantoni reported that non-bank lenders managed to get profit margins back up to about 40bp in Q3 ‘17 from single digits in the first half of the year, but depositories fared far worse in the MBA survey. A decade ago, residential lending returns were over 2%. Consider high-touch First Republic Bank (FRC), the San Francisco based lender that focuses on managing assets for high-income clientele and making jumbo mortgages for same. As of Q3 ’17, the gross spread on all of the bank’s real estate loans – which is 80% of FRC’s loan book – was just over 3%. The overall 3.1% yield for FRC’s entire loan book is half a standard deviation below its peers, according to the TBS bank Monitor. Chart 2 below shows FRC’s gross loan spread vs its asset peers. Source: FDIC/TBS Bank Monitor FRC has never particularly focused on smaller mortgages, preferring the well-bid world of jumbo loans, which the bank sells into securitizations managed by the likes of Redwood Trust (RWT) with servicing retained. Most other banks large and small have fled the low end of the residential mortgage market and focus primarily on tri-coastal jumbos over $1 million. Chase, Wells Fargo (WFC) and Bank America (BAC) are super competitive on jumbos over $1 million in urban markets. The larger institutions win business by offering APRs and other terms that are well-below that of conforming loans half that size – and barely make money. They typically keep prime jumbo loans in portfolio. Having escaped the below-prime world of FHA mortgages, overall bank loan credit in 1-4 family mortgages is pristine. The net charge-off rate in Q3 ’17 was just 0.04%, largely because home prices are rising so fast thanks to the Yellen Inflation that banks are having a hard time losing money when that rare mortgage default event occurs. In Chart 3 below, note that past due 1-4 family loans remain stubbornly high at 2.6% in Q3 ’17, this due to the backlog of foreclosures that remain in the judicial states of the Northeast. The glacial pace of foreclosures in judicial states, which often exceeds 1,000 days from default to resolution, is just one aspect of the cost of “consumer protection” for MBS investors. Source: FDIC The positive impact of rising home prices on bank credit is shown in Chart 4. In Q3 ’17, loss-given default (LGD) in 1-4s reach a new low of just 24%, the lowest observation for this metric since at least 1990. The 30-year average LGD for 1-4s is 66%, a fact that will perhaps be of note to our friends at the Board of Governors in Washington. The plummeting LGD for residential mortgages owned by banks illustrate very graphically how the actions of the Fed have boosted home prices and greatly advantaged home sellers. Source: FDIC Since banks avoid the bottom third of the US mortgage market in terms of credit quality, the credit outlook for banks is quite positive – but we still expect to see defaults slowly rise from the current low levels. Seeing a 24% LGD is a skew, an outlier. Because of the sharp supply shortage of 1-4 family homes as well as affordable apartments in many markets, we do not expect to see prices decline appreciably as the Fed ends QE. But as we told the audience in Atlanta on Friday, we don’t expect to see mortgage interest rates rising because of the dearth of duration in the bond market. Last week in The Institutional Risk Analyst , we talked about how the fact of the Fed’s ownership of $4 trillion in Treasury paper and MBS has taken away upward pressure on bond yields. Since none of the global central banks that collectively own $20 trillion plus in debt and equity hedge their positions, there is no selling pressure to push bond prices lower and yields higher. Banks and other fixed income investors are trapped in the world of “lower for longer” so long as the central banks retain their bloated securities holdings. Indeed, as we predicted during the discussion at the FRB Atlanta, we expect to see an inverted yield curve in Q1 ’18. Last week, Peter Cecchini, chief market strategist at Cantor Fitzgerald, called the flattening yield curve “the most important thing to have a clear idea about now.” This is especially true for banks and other financials, which have surged past the S&P 500 and other equity market benchmarks in the collective madness surrounding stocks in the runup to the tax cutting legislation. Sure, net-interest margins have been rising for banks, however we believe that the prospect of a flat or inverted yield curve will give investors and FOMC members reason for pause. Chart 5 illustrates the recent upturn in bank interest income even as interest expenses have risen far more slowly. So far, banks seem to have managed to keep hungry depositors at bay as yields have risen from 2015 lows, but the Fed is still effectively transferring $80 billion per quarter from depositors to banks. Note how wide the net interest margin grew in 2009 when the Fed slashed rates but yields on earning assets were still relatively high compared with today. Source: FDIC As we’ve noted in previous missives, bank returns on the $16 trillion or so in earning assets are still quite subdued at just shy of 80bps. And the market for new bank loans in sectors such as C&I and commercial real estate remain extremely competitive for larger banks, putting an effective cap on loan yields. So unless bond spreads expand and loan yields actually rise from current levels – something we think is unlikely – the bullish improvement in bank interest earnings may slow. More, if as we suspect the yield curve inverts next year, the FOMC may need to rethink its schedule for benchmark rate increases. Bank credit metrics look quite good at present – too good really. Negative net loss rates for multifamily loans and construction & development exposures remind us that the FOMC has greatly skewed the world of credit – in some cases by several ratings notches. This anomaly will eventually be reversed, revealing tens of billions worth of mispriced exposures on the books of US banks. As Chart 6 below suggests, the cost of credit for construction and development loans in the US remains badly skewed and has been negative since 2015. The degree of downward deviation from the 30-year average LGD of 60% suggests that the adjustment could be far more severe than the 2007 financial crisis – if and when a more general deflation of asset prices occurs. But it remains to be seen whether asset prices can adjust in the near term. Source: FDIC So the good news is that bank earnings likely will to continue to improve with relatively low credit costs, but a flat Treasury yield curve may change that trend. Asset and equity returns for US banks remain 1/3 below pre-2008 levels. Loan growth will probably continue to decelerate from the torrid levels of 2015 and 2016. Whether or not anyone on the FOMC gets the joke in the near term and starts to sell MBS and long-dated Treasury bonds is perhaps the most important question facing bank investors as 2017 comes to a close.

Atlanta | Is a conundrum worse than a dilemma? One of the more important and least discussed factors affecting the financial markets is how the policies of the Federal Open Market Committee have affected the dynamic between interest rates and asset prices. The Yellen Put, as we discussed in our last post for The Institutional Risk Analyst , has distorted asset prices in many different markets, but it has also changed how markets are behaving even as the FOMC attempts to normalize policy. One of the largest asset classes impacted by “quantitative easing” is the world of housing finance. Both the $10 trillion of residential mortgages and the “too be announced” or TBA market for hedging future interest rate risk rank among the largest asset classes in the world after US Treasury debt. Normally, when interest rates start to rise, investors and lenders hedge their rate exposure to mortgages and mortgage-backed securities (MBS) by selling Treasury paper and fixed rate swaps, thereby pushing bond yields higher. An essay on this very subject was published by Malz, Schaumburg et al in a blog post for the Federal Reserve Bank of New York in March 2014 ( “Convexity Event Risks in a Rising Interest Rate Environment” ). Since then, the size of the Fed’s portfolio has grown a bit, and volatility has dropped steadily. The key characteristic to note is that the Fed owns most of the recent vintage, lower coupon MBS that would normally be hedged by private investors and banks. For those of you who follow our work, this argument tracks that of our colleague Alan Boyce, who has long warned about the hidden duration risk in the bond market since the start of QE. The FRBNY post summarizes the situation nicely: “When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors’ objectives and risk tolerances.” Since the Fed and other sovereign holders of MBS do not hedge their positions against duration risk, the selling pressure that would normally push up yields on mortgage paper and longer-dated Treasury bonds has been muted. Thus the Treasury yield curve is flattening as the FOMC pushes short-term rates higher because longer-dated Treasury paper, interest rate swaps or TBA contracts are not being sold, either in terms of cash sales by the FOMC or hedging activity. Chart 1 shows 2s to 10s in the Treasury bond market from FRED. Source: FRED More, the volatility normally associated with a rising interest rate environment has also been constrained because the Fed’s $4 trillion plus portfolio of Treasuries and MBS is entirely passive. As the FOMC ends purchases of Treasuries and MBS, and indeed begin to sell down the portfolio, presumably the need to hedge by private investors and financial institutions will push long-term rates up and with it volatility. As Malz notes, “the biggest change [between 2005 and 2013] is the increase in Federal Reserve holdings, partly offset by a large reduction in the actively hedged GSE portfolio.” Yet since the modest selloff in 2013, volatility in the Treasury market has continued to fall. While it is clear that some smart people at the FRBNY understand the duration dilemma, it is not clear that the Fed staff in Washington and particularly the members of the Board of Governors get the joke. Unless you believe that the FOMC is intentionally pursuing a flat yield curve as a matter of policy, it seems reasonable to assume that the folks in Washington do not understand that reducing the size of the System portfolio is a necessary condition for normalizing the price of credit. George Selgin at Cato Institute wrote an important post this week talking about Chair Janet Yellen’s defense of paying interest on excess reserves (IOER) held by banks at the Fed (“ Yellen's Defense of Interest on Reserves ”). Selgin’s analysis raises a couple of important issues. The fact that Yellen and the FOMC will not manage IOER at or below the market rate for Fed Funds is quite telling, particularly since doing so would address many of the key criticisms of the policy. This suggests two things, first that there really is no "free" trading in Fed Funds anyway and the Fed is the market. Second that the FOMC somehow thinks that it must push higher the bottom of the band -- this despite the huge net short duration position of the street and the $4 trillion passive Fed portfolio. The more urgent question is Yellen's view of a trade off between QE/open market operations and IOER that Selgin illustrates very nicely. The FOMC seems to think that merely not growing the portfolio or slowly selling is an option while they raise benchmark rates like IOER and Fed Funds. In fact, reducing the portfolio always was the first task, before changing benchmark rates. Especially if one is cognizant of current market conditions. Unless the FOMC changes its approach to managing its $4 trillion securities portfolio, either through outright sales or active hedging, it seems likely that the Treasury yield curve will invert by Q1 ’18. The Fed could sell the entire system portfolio and the street would probably still be short duration due to low rates and continued QE purchases by ECB, BOJ, etc. And to repeat once again, the agency mortgage securities market is down 30% on issuance YOY. Again, the FOMC does not seem to appreciate that the yield curve must invert, unless the bond trading desk at the FRBNY is actively selling and/or hedging all of the MBS and even longer dated Treasury paper. Some analysts such as Ed Hyman ( Barron’s , “ A Smooth Exit Seen for Mortgage Securities, ” 11/20/17) believe that banks will increase purchases of agency paper as the Fed unwinds QE. We beg to differ. Bank holdings of MBS as a percentage of total assets has barely moved in years. But more to the point, one has to wonder if Yellen and other members of the FOMC appreciate the trap that has been created for holders of late vintage MBS. The Fed has suppressed both interest rates and volatility via QE, as shown in Chart 2 below: Source: Bloomberg As and when the balance between buyers and sellers in the MBS market slips into net supply, volatility will explode on the upside and the considerable duration extension risk hidden inside current coupon Fannie, Freddie and Ginnie Mae MBS could prove problematic for the banking industry. “The duration extension risk goes turbo if we see rates up, volatility up and a curve steepening,” notes Boyce. Or as Malz noted succinctly in 2014: “When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors’ objectives and risk tolerances.” #FOMC #CATO #GeorgeSelgin #durationrisk #MBS #Bonds

President Donald Trump just completed a relatively upbeat swing through Asia, but made some ominous references to future trade action in his speeches, policy changes that could be focused primarily on China. This week in The Institutional Risk Analyst, we feature a discussion with Leland Miller, CEO of China Beige Book International and one of the best observers of China in the West. He’s also a Non-Resident Senior Fellow for the Asia Security Initiative, Brent Scowcroft Center on International Security, at the Atlantic Council. We spoke to Lee in New York. The IRA: Lee, let’s pick up where we left off more than a year ago, talking about the progressive accumulation of political power under Xi Jinping. How do you assess his success and did he exceed your expectations in terms of the ease with which he has consolidated his grip on power? Miller: He’s fulfilled all of them and probably more. Everyone was pretty much of the mindset over the past year that this consolidation of power by Xi was a done deal. The question was to what degree and how was he going to memorialize this power? How would the systems change to reflect that power? He went just about as far as anyone thought he would go and actually had his thought elevated to the same level as Mao Zedong. The IRA: What does that mean? Is Xi now a demigod in the communist pantheon? Miller: The Chinese Communist Party adopted Xi’s thought as part of the Party Constitution. As long as Xi Jinping is alive, he calls the shots – period. Being part of the constitution puts him on a level that only Mao Zedong himself has achieved, and ensures that his views alone provide the intellectual foundation for all of the Party’s actions. From here on out he is “the man,” whether he holds the title of President or Party Secretary. This is his show going forward. The IRA: Describe how this evolution from collective leadership to cult of personality occurred? Is this just another example of the model of one man rule in China? We are reminded of George Orwell’s classic “Animal Farm,” where the character of the pig Napoleon gradually murders all of his rivals. Miller: Well, it has not happened in a long-time, at least since Deng Xiaoping. There has been a default towards consensus leadership for decades. The people in authority had balancing needs. There were various personalities and factions who jockeyed for position within the Party in a compromise process. This time around, however, it was not a consensus process. Xi has been working for the past five years to take down potential rivals in the Communist Youth League, as well as Bo Xilai and his cabal in Chongqing, who were purged after building up a rival power base. Xi’s ally Wang Qishan went after all the other rival power bases via the anti-corruption campaign, taking them down one by one. Xi is now in control of all of the organs of power in China and that is virtually certain to be the case going forward. The IRA: Well, that’s fascinating, especially with the coincidence of the dynastic purge underway in Saudi Arabia. Is there a power base behind Xi or is he now moving solely by the sheer supremacy of his personality? Xi Zhongxun Miller: Xi was once part of a group that included a number of prominent princelings. His father, Xi Zhongxun , was a famous revolutionary. Then for years he was closely associated with has been called the Zheijiang faction, which refers to the group of people around Xi who served in trusted positions when he was Party Secretary of Zheijiang province. These people now make up a good chunk of the people in Xi’s inner orbit. But even so, there is no real challenge to his power anywhere in the party or the government. He even purged the military and replaced the top officials with younger officers more beholden to him for their positions and influence. The IRA: And created many enemies in the process. Miller: There was enormous turnover in the military, unprecedented changes. There were changes not just in the Central Military Commission, but in the top ranks of the military itself. As I said, this leaves Xi a virtually unchallenged leader and it means that if China is going to do any large-scale restructuring of its system, it is much better positioned to do it now. That doesn’t mean he will opt to do that, it just means that this is a better situation for making such changes if that ends up being what Xi decides to do. The IRA: So how does this change the equation for the US? Or the Russians? Miller: I don’t think it has much effect on Big Power relations. The only real change is that other powers now understand that they are dealing with a core decision maker and that consensus leadership is a thing of the past. The IRA: There are more and more analysts in the West seemingly willing to believe that China will not grow at 7% annually forever. Does the rise of Xi have any impact on the Chinese economy, either immediately or the longer term? Miller: It’s funny, two years ago the people who had been proclaiming that China could grow at 7% forever completely re-wrote their forecasts and started calling for a dramatic economic slowdown or crash. Now, with things looking much sunnier of late, most of those folks have gone back to their old thinking—predicting that China can keep up relatively high growth indefinitely. But they misunderstand the broader context, what was given up to get China this 2017 burst of growth. Analysts have become so ebullient about China that they miss the forest for the trees. The IRA: How so? What is wrong with the never ending China bull case? Miller: They had a great 2017 performance. A year and a half ago we were in the midst of a global contagion that resulted from a crisis in China over currency worries and capital outflows. This type of weakness was obviously unacceptable entering into a year of political leadership change, so they stepped up their interventions and made sure the economy recovered—and then some. So no question, there was an unmistakable on-year recovery in the Chinese economy virtually across the board. The IRA: Where is the catch? Miller: Everyone is on the same page right now in terms of seeing a strong 2017 economy, but the mistake analysts make is seeing this as the “new normal” for China. The Party decided that it would pull all of the stimulus levers over the past year and that’s what made 2017 such a great year for the economy. But this was done at a considerable cost—no deleveraging, an outright reversal of rebalancing, huge stimulus on both the fiscal and monetary sides—so naturally the economy will slow in the coming year as the anxiety cools down. And that’s assuming all else stays the same, which is extremely unlikely. The IRA: We had talked a few months ago about Xi wanting no surprises in 2017 and that seems to be the case. Why is it that the foreign analyst community fails to appreciate the political dimension in China? Miller: We called it the Party Congress put. Every person in China knew that the economy would be kept on track this year because the leadership couldn’t afford any problems in the run-up to the Congress in October. But you’re potentially looking at a much different 2018. They were able to hit this level of economic performance in 2017 because there were no internal or, surprisingly, external shocks. There was no aggressive tightening by global central banks, no strong dollar. In fact you had a very weak dollar through most of 2017. There were no major geopolitical tensions, nothing percolating negatively for them in the South China Sea. And most importantly, there were no Trump trade tensions, none. But we think most of these factors will reverse in 2018. The IRA: Isn’t it remarkable that the US media saves most if not all of its vitriol for Vladimir Putin, while with Uncle Xi in China the honeymoon continues. President Trump’s talk on trade has been remarkably tame with China compared with his campaign rhetoric. His trip to Asia has also been mostly free of aggressive rhetoric. Are we seeing a new Donald Trump? Miller: We think that the good times will be ending soon enough, maybe as soon as early 2018. New problems are clearly brewing for China next year and they are all pointing in one direction. We could even see the Trump Administration take trade action against China in the early months of next year. You have a president who promised tough action against many trade partners and especially China, but nothing so far. This will change. The IRA: So what about it is going to change? Trump likes to have leverage in all of his relationships, perhaps this is how he gets leverage politically and, in his own mind at least, with China. Miller: Everything politically is pushing us towards a trade conflict with China in 2018. Donald Trump wants tariffs. He promised tariffs during the campaign. Trump wants to fix the economic imbalance with China through tariff actions. He talks about this constantly behind closed doors, but so far there have been forces in the White House that have kept him from taking these steps. As the mid-terms elections approach, however, Trump must turn up the heat on trade to be able to reclaim these issues. The ability of moderates in his circle to prevent Trump from imposing tariffs on China has been impressive so far, but his desire to do something big on trade will likely be too powerful to stop in the coming year. The IRA: The global financial markets are really not prepared for such a turn of events. We could easily see the US equity markets trade off by double digits if China-US tensions flare up significantly. Does that possibility figure into the Trump calculations? How does trade action by the US impact the Chinese economy? Miller: The key issue is perception in the West. People have gotten so over-confident on China recently. One of the leading China watchers just got up at a conference last month and declared that China has already had its hard landing and that the next two years are going to be wonderful. People have gotten very cocky about China’s performance, so any volatility will shake foreign investors and markets because expectations are so high. When the US initiates the first trade action against China, perhaps as early as early 2018, it is going to take a lot of people by surprise. How China reacts will be key, both for global markets and for its own economy, but have no doubt that the first move will be made by Trump. He wants a trade war with China. Politically, he needs a trade war with China. How Xi reacts will determine the amount of collateral damage that follows. The IRA: Thanks Lee.

Writing this week in Barron’s , Harvard economist Martin Feldstein nails the proverbial issue of excessive debt square on when he notes that European Central Bank chief Mario Draghi has run out of runway when it comes to policy prescriptions. He writes: “One of the goals of large-scale bond purchases—so-called quantitative easing— was to drive down long-term interest rates in order to stimulate business investment and housing construction. But with long-term interest rates now close to zero, bond purchases would not be able to lower them any further.” But Professor Feldstein then concludes that when the inevitable economic slowdown comes in Europe, “an appropriate response to this dilemma may be a policy of coordinated fiscal expansion.” The fact that the world from Beijing to Brussels is literally choking on debt – thus Draghi’s infatuation with zero or even negative interest rates – does not dissuade Feldstein and other economists from recommending ever more debt-funded fiscal expansion. Of course, if you ask ECB chief Mario Draghi, the ECB still has plenty of room to maneuver. All central bankers suffer from the deadly sin of hubris. Last week, we posted our thoughts on the tactical situation facing the new Federal Reserve Chairman-designate Jerome Powell on Zero Hedge . We asked: "How do you think, Governor Powell, equity markets will react if Chair Yellen inverts the yield curve on her way out the door?" Might ask Governor Draghi the same question. As US interest rates rise and the policy gap between Washington and Brussels widens, our friends in Europe are going to be faced with some profound challenges. Chief among them is how to prevent Italy and other EU member states from defaulting on their debts. And the longer Draghi waits to “normalize” monetary policy, the more investors and markets will question the solidity of the European economic rebound. Wolfgang Munchau writes in the FT : “Even after a decade-long recovery, the ECB may never be able to halt asset purchases.” Ditto. His comment implies that Europe is slipping into a Japan-like state of permanent debt repudiation via QE to manage the fiscal crisis for its weaker members. But insolvent countries are just the beginning of the world's debt problem. Another important read in Barron’s this week features JPMorgan industrial analyst Stephen Tunsa talking about General Electric (NYSE:GE). Tunsa thinks that the dividend on the common shares -- now changing hands around $22 -- is going to be cut to better align with actual cash flow. He also sees the once high-flying GE, formerly a blue chip equity name, soon trading in the teens. Tunsa opines: “I think most active managers expect a [dividend} cut, but a smaller one, to the 60- to 70-cent range. Certainly if it’s below 50 cents, the stock should go down. I don’t think this stock deserves a market yield, which is around 2%, so a 3% dividend yield on 50 cents or below gets you to a share price in the teens.” Of interest, Barron’s reminds us that the financial-industrial conglomerate assembled by Jack Welch remains among the more complex financial services companies in the US even after shedding its status as a regulated financial holding company. Not only does GE Capital still finance much of the receivables of the industrial business, but the company also keeps many of these assets on its own balance sheet under complex leasing arrangements. GE notes in its most recent 10-K that its non-US activities “are no longer subject to consolidated supervision by the U.K.’s Prudential Regulation Authority (PRA). This completes GE Capital’s global exit from consolidated supervision, having had its designation as a Systemically Important Financial Institution (SIFI) removed in June 2016.” But past financial machinations still represent big a negative for GE shareholders. The company’s insurance unit, for example, remains a source of future potential financial risk due to poorly priced long-term care insurance contracts. In its latest public disclosure, which Barron’s notes is shrinking in terms of quality and quantity of its content, GE demurred on whether GE Capital will have to take additional reserves for its insurance unit. “A charge related to a probable [reserve] deficiency is not reasonably estimable at September 30, 2017,” GE notes in its last 10-Q. “Until the above described review has been completed we have deferred the decision whether GE Capital will pay additional dividends to GE.” Really? Could GE shareholders expect an unwelcome Christmas present from the new CEO John Flannery? Tunsa concludes: “If these issues are as bad as they seem from a cash-flow perspective, there’s a systemic problem that won’t be quickly fixed with cost cuts and portfolio tweaks.” The problem with GE, or course, is that they are migrating back towards righteousness after years and years of high-risk financial engineering under Neutron Jack and his hyperactive management progeny. By aspiring to profitability and stability, the story has become entirely boring and subject to the laws of financial physics. Flannery would do better to emulate Amazon (NASDAQ:AMZN) and especially Telsa (NASDAQ:TSLA) when engaged in corporate renovation. TSLA trades on a price-to-loss ratio, a unique measure that allows for unlimited growth. Unfortunately, Tesla shares closed down last week, in part because the Trump tax cutting proposal would scrap the $7,500 federal tax credit for electric cars. Much like AMZN, TSLA is about selling the future rather than present day profits. With the setbacks recently reported by TSLA in terms of actually making cars, Elon Musk and his minions dare not even speculate about eventual profitability at this stage of the game. When confronted by the most recent failures to meet manufacturing goals, Musk pivoted on a dime and announced the construction of a new factory in China. By comparison, GE sports a $175 billion market cap vs $51 billion for TSLA, which is still near its all-time high but is unprofitable and has $10 billion in high-yield debt. Cutting tax rates is great for the profitable, but of limited value to those like TSLA who have yet to report taxable income and can’t seem to hit operational goals. But investors love TSLA and hate GE, and perhaps with good reason. Mark Twain said it is easier to fool people than to convince them they’ve been fooled, a statement tailor made for the TSLA phenomenon. Perhaps that’s why TSLA continues to raise new money to feed its growing burn rate, this even as GE sinks. Meanwhile, the major automakers show signs of ganging up on the new era car maker TSLA. Short-seller Jim Chanos said last year, after the $2.6 billion merger with SolarCity Corp, that Tesla Motors is a "walking insolvency." Agreed. TSLA certainly has negative cash flow, but unlike GE, it has a positive narrative. Henry Ford said that you cannot build a reputation on what you are going to do, the polar opposite of the approach by TSLA founder Elon Musk. Ford Motor Co returned its seed investors’ capital in full after the first year of operations, but investors in TSLA may never seen dollar one. Of course, a century ago cars were the new thing, while today electric cars are a strange novelty meant to make wealthy people feel responsibly green – even if lithium batteries are a dirty and expensive way to store and deliver energy. In his effort to change the world, Musk is fighting the tides of history as well as the relentless logic of accrued interest. Musk's love child is also in a technological race with firms that want to put a sustainable propulsion source inside electric cars. The Economist reports that Mercedes-Benz is planning to introduce a plug-in hybrid SUV that combines a battery pack with a fuel-cell generator. This design is meant to replace internal-combustion engines when the EU plans to go entirely electric in 2040. We continue to believe that hybrids are the answer for clean transportation, even if the auto industry must kowtow to political correctness and build absurd battery powered cars. But forget the batteries and firms like TSLA that are pursuing this retrograde technology. Call us when the all electric Ford F-250 Super Duty truck with a compact gas turbine for power is ready for a test drive. And, no, we’re not buying or selling short TSLA or GE, but we are still accumulating a position in PayPal (NSADAQ:PYPL), one of the more interesting names in fintech. BTW, hard copies of "Ford Men: From Inspiration to Enterprise" are again available on Amazon after a several week hiatus. Apologies for the operational issues. #GE #TESLA #Powell #Feldstein #Barrons #China #Draghi #ECB #industrial

New York | During our travels over the past two weeks, we tried to keep up with the financial press, particularly the growing sense of unease felt by many observers with the relentless rise of valuations for equities and other asset classes engineered by the Fed and major central banks. Suffice to say the number of queries we receive about bank stocks being overvalued has soared. Last week saw some real gems from the world of crypto currencies. Bitcoin and the enabling technology known as “blockchain” are just the latest shiny objects to fascinate the less cautious members of the investing public. The folks at Grant’s Interest Rate Observer flagged this precious headline from Bloomberg News : “This Company Added the Word ‘Blockchain’ to Its Name and Saw Its Shares Surge 394%” The world of “investing” in blockchain schemes has always given us a feeling of amazement, but tempered with a tinge of chagrin for those credulous souls caught up in this web of intellectual fraud. Sure blockchain has some interesting attributes, but other than enabling the bitcoin phenomenon, it has limited uses that make commercial sense. Blockchain rather blatantly violates the Three Laws of technology investing – cheaper, better, faster – but nobody seems to care. Even more amusing than blockchain, however, is the fact that some of the sponsors of various “initial coin offerings” of nouvelle crypto currencies have taken the position that the ICO is an act of charity and that the investment received is a “non-refundable donation” rather than a distribution of a stake or equity in the issuer. While ICOs seem to be clearly at odds with the anti-fraud provisions of the Securities Act of 1934, so far the Securities and Exchange Commission and Department of Justice have been unwilling to put an end to the marketing of these schemes in the US. The SEC rightly describes crypto currencies as “tokens” that may be considered securities under US law, yet the widespread public confusion over these get rich quick schemes has overwhelmed the government’s willingness to call out this activity. One reason why so-called crypto currencies have gained such a following is that there is no real money to be found anywhere in the world. In the US, the legal tender laws of the 1860s forced members of the public to accept paper money – greenbacks – “for all debts, public and private,” this to help finance the Civil War. When Franklin Delano Roosevelt confiscated gold held by the public in the 1930s, paper money ceased to be a store of value directly convertible into gold or silver by individuals. Today what people refer to as “money” operates as a means of exchange and a unit of account, but the dollar ceased to be a store of value decades ago. An item purchased for $20 in 1913 when the Federal Reserve System was created would cost nearly $500 today, a cumulative rate of inflation of 2,400%. So much for central bank independence. At least the Treasury notes that circulated in the US prior to the Civil War paid interest. Today’s greenbacks issued by the Federal Reserve System are just memorials to dead presidents. More recently, central bankers have decided to confiscate private wealth represented by even fiat paper money via such means as negative interest rates and market intervention disguised by misleading labels like “quantitative easing.” As we’ve discussed before, negative interest rates imply the global confiscation of private financial assets for the benefit of debtors, especially public sector debtors. Of note, in his last blog post, John Taylor examines a thesis advanced by Allan Meltzer that QE was a policy of competitive devaluation. The US moved first, and others followed, as one of our colleagues noted last week. But the only thing that has resulted is a vast flow of capital back into the US economy. With almost $10 trillion in negative yielding bonds globally, dollar assets have become a refuge from global confiscation by the European Central Bank and Bank of Japan. Mark Twain alleged that “there is no distinctly native American criminal class except Congress,” but we wonder what would he say about the bureaucrats at the Federal Reserve Board, ECB or the BOJ? Indeed, when you survey the world of investing, it is hard to get annoyed with the starry-eyed followers of bitcoin. Call bitcoin virtual tulips. The crypto adherents at least have decided to reject the authoritarian world of fiat paper currencies issued by insolvent governments and instead embrace an alternative standard. Professor Larry White wrote in a blog post entitled “Blockchain + Gold”: “The Bitcoin system has the great virtue of securely sending value directly from stranger to stranger. It is open to anyone, anywhere in the world. The sender does not need to trust the recipient, nor any bank or other institution, to accurately record the transfer.” And what can you say about those individuals who lack the courage to take a flutter in bitcoin, but comfort themselves by talking about the “benefits” of the inefficient blockchain tech behind it? Bitcoin holders at least have the possibility of gain, but “investors” in blockchain are literally shoveling money into the furnace. Several years on and many billions of dollars later, we still have yet to see one example of a blockchain outside of the bitcoin instance that makes any economic sense. Meanwhile, we would be remiss if we did not note the ten-year anniversary of the shotgun wedding of Merrill Lynch and Bank of America (NYSE:BAC). We got several queries about the anniversary of this combination last week. One investment manager confessed during a private session in an office on Park Avenue that BAC was his best performing position, but then asked nervously if a 50% run up in less than a year is “cause for concern.” We referred to the excellent piece by Chris Cole of Artemis Capital, who notes that the “investment ecosystem has effectively self-organized into one giant short volatility trade like a snake eating its own tail, nourishing itself from its own destruction.” Cole goes on to note that in addition to central banks buying $20 trillion in public and private assets, public companies have repurchased almost $4 trillion in stock – this by issuing debt. “Like a snake eating its own tail, the equity market cannot rely on share buybacks indefinitely to nourish the illusion of growth,” notes Cole. Ditto. Of course big bank stocks are “overvalued” in terms of earnings or revenues, but do such measures really matter in a world without value? When you have global central banks gunning all asset prices in a desperate effort to avoid a sovereign debt default starting in Japan and then Europe, pedestrian metrics like price/earnings ratios and net-present value have little relevance. Remember, the reason that the Fed slammed Merrill Lynch into BAC a decade ago was in a desperate effort to preserve the US Treasury’s access to the bond market. In those dark days of 2008, primary dealers were collapsing left and right. Dealers operated by Washington Mutual, Bear, Stearns & Co, Countrywide and Wachovia all evaporated in a matter of days. When all's said and done, the Federal Reserve Board cares not about inflation or employment or the safety and soundness of banks and the financial system. The paramount concern of the Fed is to preserve the ability of the US Treasury to issue more debt and thereby keep the great game going awhile longer. The growing pile of public debt in the US is why price stability will never be part of the mix -- unless and until the Treasury is forced to live within its means. This is also why dollar-alternatives like bitcoin, imperfect and even fraudulent as they may be, will continue to capture the attention of those seeking to escape the economic tyranny of fiat paper money. Finally, we cannot fail to mention that The IRA's Chris Whalen has been included in the list of enemies compiled by the minions of George Soros. We are in decidedly good company. David Ignatius. Ann Coulter. The editor of The Nation . The "tout US journalism." Apparently everybody who is anybody in the world of media has earned the enmity of Mr. Soros, the architect of the Ukraine disaster and one of the world's great war mongers. We bask in his scorn. #bitcoin #blockchain #assetbubble #Soros

Tomás de Torquemada (1420-1498) “Assassins Creed” Denver | This week The Institutional Risk Analyst is in Rocky Mountain country for the Mortgage Bankers Association meeting. The event comes amid a mixed picture for the mortgage finance industry. On the one hand, lending volumes have improved a bit over the course of the summer, but refinance volumes are still down compared with 2016, the result of volatile interest rates and a growing shortage of homes for sale. Chart 1 below shows the most recent MBA projections for residential mortgage origination for 2017 and beyond. Source: MBA On the bright side, however, seven years of Spanish Inquisition focused on the mortgage industry by state and federal regulators seems to be slowly coming to an end. The big news came last week when HUD Secretary Ben Carson said that the government’s use of the Civil War era False Claims Act as a nuclear weapon against mortgage lenders could soon be coming to an end. He asked the obvious question, namely why the US government ever began to use this 1800s law meant to prevent war profiteering against American mortgage firms. “I’m not exactly sure why there had been such an escalation previously, but the long-term effects of that escalation is obviously providing fewer appropriate choices for consumers,” Carson said of the use of the False Claims Act’s criminal penalties to bully lenders into big settlements with the Department of Justice. Housing Wire reports that he added. “And that’s exactly the opposite of what we should be doing.” Another bit of positive news came when Anthony Alexis, the Consumer Financial Protection Bureau’s enforcement chief (aka the "Inquisitor"), announced that he is stepping down after more than two years overseeing the agency's efforts to “combat abuses by the financial industry,” in the words of National Law Journal . The publication goes on to note that the departure is “certain to fuel speculation that Director Richard Cordray will leave soon to pursue the Ohio governorship.” Like the Tribunal of the Holy Office of the Inquisition in 15th Century Spain, the CFPB has a persecutorial mentality -- but without the burden of actually proving that a crime was committed. That is, the CFPB is all about politics and punishment. Yet rather than ensuring anything like a fair and transparent market for consumers in the market for mortgage finance, the CFPB instead extracts payments from private business to feed the Progressive faithful. This includes members of the trial bar who prosecute shareholder class action lawsuits, hedge funds who engage in short-sales of companies targeted for punishment, and elected officials operating in the public sector. Under the leadership of Mr. Alexis and Director Cordray, the CFPB frequently demanded payments from mortgage companies without any actual evidence of wrongdoing. This follows the familiar pattern set by Mr. Cordray when he was attorney general of Ohio, where he unsuccessfully attempted to extort millions of dollars from several private mortgage firms we know well. Big banks, not wanting to take the headline risk of litigation, would pay the CFPB’s extortionate demands. The non-bank mortgage companies, on the other hand, lacking the excess cash of a government sponsored bank, chose to fight in court rather than accede to the CFPB’s blackmail. But the larger point is that the CFPB has taken government regulation of consumer finance to a new height of capricious arrogance. Consumers ultimately pay the cost for this exercise in Progressive punishment. Sadly for Mr Alexis and his remaining colleagues at the CFPB, the bull market in former regulators has ebbed since the election of Donald Trump to the White House. Prior to November 2016, former employees of the CFPB could demand a hefty price in the private sector world of lobbying and regulatory relations for their inestimable talents. When you have a regulator as brutal and arbitrary as the CFPB, an assortment of fixers are advisable. But no more. With the impending lobotomy of the CFPB now at hand, the street value of former CFPB regulators has fallen to a discount, says one well-placed Washington lawyer. In addition to Director Cordray, Senator Kamala Harris (D-CA) is another example of a state level politician who achieved national status because of the emergence of “consumer protection” as a key part of identity politics. Some observers hope that Democrats will abandon identity politics and help liberalism become once more a unifying force for the "common good," but we see no evidence that the likes of Cordray, Senator Elizabeth Warren (D-MA) or Harris have gotten that memo. Some observers have speculated that the states will pick up the ball when it comes to the regulatory Inquisition in the world of consumer finance. But sad to say, the CFPB was the point of the spear for militant Progressives seeking to make the world safe for trial lawyers. Their political allies such as Mr. Cordray, Ms Harris and their fellow traveler, Senator Warren, will be profoundly frustrated once the CFPB is forced to assess the actual harm to consumers before issuing a demand for payment with an enforcement notice. Aaron Klein of Brookings Institution notes in an exchange on Twitter that “Unfair, abusive and deceptive practices (UDAP) has been illegal under FTC Act since 1938. Somehow capitalism has survived & thrived.” Survive is an apt description, but just barely. Capitalism died with the Robber Barons and the New Deal, but we digress. Fact is, regarding states picking up enforcement, they will have some difficulty because state laws are general tighter and with more precedent allowing less discretion to investigators. When CFPB was created, long-standing proposals from state law were brought into federal, but with a clean slate for interpretation. The CFPB represents a dangerous evolution of the UDAP principle as enforced by the Federal Trade Commission, one that lacks any notion of due process or fairness. As conceived by Dodd-Frank, the CFPB’s mission is to attempt to condemn, a priori , millions of Americans who work in the world of housing finance, from realtors to appraisers to loan underwriters to mortgage servicers to investors. No one who believes in fairness and the rule of law should support the behavior of the CFPB over the past six years. The departure of Mr. Cordray for his next adventure cannot come soon enough for many in the housing market. To see the actual economic cost of the CFPB’s reign of terror, consider one of the larger and better known names in the world of mortgage finance, New Residential Investment Corp (NYSE:NRZ). While the stock for this large real estate investment trust (REIT) is trading near its 52-week high at around $17, the $2 dividend gives it a yield over 11%. NRZ specializes in holding residential mortgage servicing rights or MSRs. When you do the math, the overall cost of capital including debt for this large, $5 billion market cap buyer of residential MSRs is well into the teens. Compare this to a government-sponsored bank such as Wells Fargo (NYSE:WFC) with an equity dividend yield under 3% and you begin to understand the enormous disadvantage of non-bank firms operating in the world of mortgage finance, especially compared with GSEs. Table 1 below comes care of our friends at Kroll Bond Ratings and shows dividend yields NRZ and other mortgage REITS. The cheapest capital for REITs generally comes from common equity and preferred shares, not debt. Note that there are a couple of outliers on the list with yields in mid-double digits, which pull up the average to 12% for these three dozen names. The 9% median for the group illustrates the skew. Keep in mind that NRZ and its affiliates in the constellation created by Fortress Investment Group (NYSE:FIG) have experienced relatively few regulatory issues and little headline risk, yet the stock trades at a deep yield discount to banks (and a 6 price/earnings ratio vs double digits for banks) with significant mortgage exposure like WFC or even other mortgage REITs. When investors look at NRZ or other players in the world of residential mortgage finance and MSRs, they generally see enormous regulatory danger and price the capital accordingly. But notice that Redwood Trust (NYSE:RWT), a REIT which specializes in acquiring and securitizing prime jumbo mortgages, has one of the lowest dividend yields in the group at just 6.7%. Going into 2018, the mortgage industry is looking forward to a more balanced and productive relationship with both regulators and policy makers. In the past year, CFPB officials have rather bombastically demanded increased investments in technology by mortgage companies. We frequently ask our friends in the regulatory community just how they expect such investments to be financed when a large part of the industry is under water in terms of profitability, this due to increased regulatory costs. As 2017 draws to a close, equity returns in the mortgage industry have never been lower. Achieving a more reasonable balance between protecting consumers from actual harm and helping the mortgage finance sector restore profitability (and sustainability) should be an important goal for the Trump Administration and the state and federal regulators responsible for enforcement. More than a few large non-bank servicers are for sale, though perhaps not the names that first come to mind. And banks continue to migrate away from the government guaranteed loan market and Ginnie Mae. A key goal for HUD Secretary Carson and his colleagues at the Federal Housing Administration ought to be restoring fairness to the relationship between private mortgage firms and the federal government. A big part of the problem starts with the use of the False Claims Act by the Department of Justice, an absurd policy that is hurting consumers by driving some of the largest players out of the FHA market. But the DOJ’s use of Civil War era law to intimidate mortgage firms is not the only reason why banks have fled the FHA. The sad fact is that residential mortgages have the lowest return on capital, both nominally and in risk-adjusted terms, of any asset that an insured depository institution can originate. Selling a residential mortgage loan creates additional incremental risk, one reason many banks are reducing loan sales and retaining the mortgages that they are willing to underwrite. So while changing the policies of the DOJ regarding FHA claims will be a big improvement, it will not be sufficient to bring commercial banks back into the FHA market. Changes must be made in the way that the CFPB regulates banks as well as non-bank companies before the returns available in residential mortgage lending will begin to approximate the risks.

The Hague | Almost as soon as it started, the excitement surrounding earnings for financials in Q3 2017 dissipated like air leaving a balloon. Results for the largest banks – including JPMorgan (NYSE:JPM), Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) – all universally disappointed, even based upon the admittedly modest expectations of the Sell Side analyst cohort. Bank of America (NYSE:BAC), the best performing stock in the large cap group (up 60% in the past year), disappointed with a $100 million charge for legacy mortgage issues. Despite strong loan growth, year-over-year BAC's net revenue is up about 5% but actually fell in the most recent period compared with Q2 '17. As with many other sectors, in large-cap financials there was little excitement, no alpha -- just slightly higher loss rates on loan portfolios that are growing high single-digits YOY. Yet equity valuations are up mid-double digits over the same period. The explanation for this remarkable divergence between stock prices and the underlying performance of public companies lies with the Federal Open Market Committee. Low interest rates and the extraordinary expansion of the Fed's balance sheet have driven asset prices up by several orders of magnitude above the level of economic growth, as shown in Chart 1 below. Meanwhile across the largely vacant floor of the New York Stock Exchange, traders puzzled over the latest management changes at General Electric Co (NYSE:GE), the once iconic symbol of American industrial prowess. Over the past year, GE's stock price has slumped by more than 20% even with the Fed's aggressive asset purchases and low rate policies. Just imagine where GE would be trading without Janet Yellen. To be fair, though, much of GE’s reputation in the second half of the 20th Century came about because of financial machinations more than the rewards of industry. A well-placed reader of The IRA summarizes the rise and fall of the company built by Thomas Edison: “For years under Welch, GE made its money from GE Capital and kept the industrial business looking good by moving costs outside the US via all kinds of financial engineering. Immelt kept on keeping on. That didn't change until it had to with the financial crisis. No matter what, untangling that kind of financial engineering spaghetti is for sure and has been a decade long process. No manager survives presiding over that. Jeffrey Immelt is gone.” Those transactions intended to move costs overseas also sought to move tax liability as well, one reason that claims in Washington about “overtaxed” US corporations are so absurd. Readers will recall our earlier discussion of the decision by the US Supreme Court in January not to hear an appeal by Dow Chemical over a fraudulent offshore tax transaction. The IRS also caught GE playing the same game. Indeed, US corporations have avoided literally tens of trillions of dollars in taxes over the past few decades using deceptive offshore financial transactions. Of note, the Supreme Court’s decision not to hear the appeal by Dow Chemical leaves offending US corporations no defense against future IRS tax claims. Like other examples of American industrial might such as IBM (NYSE:IBM), GE under its new leader John Flannery seems intent upon turning the company into a provider of software. Another reader posits that “they’re going to spend a decade selling the family silver to maintain a dividend and never make the conversion they would like and never get the multiple they want. GE is dead money at a 4% yield, which given some investors objectives – retirees and the like -- might not be such a bad thing.” The question raised by several observers is whether the departure of Immelt signals an even more aggressive “value creation” effort at GE that could lead to the eventual break-up of the company. Like General Motors (NYSE:GM), GE has been undergoing a decades long process of rationalizing its operations to fit into a post-war (that is, WWII) economy where global competition is the standard and the US government cannot guarantee profits or market share or employment for US workers. GE's decision this past June to sell the Edison-era lighting segment illustrates the gradual process of liquidation of the old industrial business. Henry Ford observed that Edison was America’s greatest inventor and worst businessman, an observation confirmed by the fact that Edison’s personal business fortunes declined after selling GE. In fact, the great inventor died a pauper. And of the dozen or so firms that were first included in the Dow Jones Industrial Average over a century ago, GE is the only name from that group that remains today. But the pressure on corporate executives to repurchase shares or sell business lines to satisfy the inflated return expectations of institutional investors is not just about good business management. The expectations of investors also reflect relative returns and asset prices, which are a function of the decisions made in Washington by the FOMC. Fed Chair Janet Yellen may think that the US economy is doing just fine, but in fact the financial sector has never been so grotesquely distorted as it is today. Let’s wind the clock back two decades to December 1996. The Labor Department had just reported a “blowout” jobs report. Then-Federal Reserve chairman Alan Greenspan had just completed a decade in office. He made a now famous speech at American Enterprise Institute wherein Greenspan asked if "irrational exuberance" had begun to play a role in the increase of certain asset prices. He said: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.” In the wake of the 2008 financial crisis, the FOMC abandoned its focus on the productive sector and essentially substituted exuberant monetary policy for the irrational behavior of investors in the roaring 2000s. In place of banks and other intermediaries pushing up assets prices, we instead have seen almost a decade of “quantitative easing” by the FOMC doing much the same thing. And all of this in the name of boosting the real economy? The Federal Reserve System, joined by the Bank of Japan and the European Central Bank, artificially increased assets prices in a coordinated effort not to promote growth, but avoid debt deflation. Unfortunately, without an increase in income to match the artificial rise in assets prices, the logical and unavoidable result of the end of QE is that asset prices must fall and excessive debt must be reduced. Stocks, commercial real estate and many other asset classes have been vastly inflated by the actions of global central banks. Assuming that these central bankers actually understand the implications of their actions, which are nicely summarized by Greenspan’s remarks some 20 years ago, then the obvious conclusion is that there is no way to “normalize” monetary policy without seeing a significant, secular decline in asset prices. The image below illustrates the most recent meeting of the FOMC. The lesson for investors is that much of the picture presented today in prices for various assets classes is an illusion foisted upon us all by reckless central bankers. Yellen and her colleagues seem to think that they can spin straw into gold by manipulating markets and asset prices. As Chairman Greenspan noted, however, “evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.” While you may think less of Chairman Greenspan for his role in causing the 2008 financial crisis, the fact remains that he understands markets far better than the current cast of characters on the FOMC. Yellen and her colleagues pray to different gods in the pantheon of monetary mechanics. As investors ponder the future given the actions of the FOMC under Yellen, the expectation should be that normalization, if and when it occurs, implies lower returns and higher volatility in equal proportion to the extraordinary returns and record low volatility of the recent past.

Happy Columbus Day! Last week financials continued their relentless march toward the sky as investors chased the happy prospect of higher interest rates from the Federal Open Market Committee and maybe even tax cuts from Congress. In a world with too much debt and regulation, and too little economic growth as a result, driving financials (and all other asset classes) up to valuations not seen since the roaring 2000s is a fool’s errand, especially when you notice that credit spreads remain largely unaffected by the threat of “tightening” by the US central bank. As we noted last week, credit spreads are so constricted and lending volumes so weak that it is becoming increasingly difficult for larger banks and other intermediaries to earn a profit on old fashioned lending. Yet the members of the FOMC continue to think of current policy as a form of “stimulus.” The sad fact is that most Fed governors and staff economists don’t really know how to think about banks or the credit markets. Like their collaborators in the financial media, Fed officials largely think of benchmarks like Fed funds or the discount window, but it is credit spreads that really matter, both to bank earnings and economic growth. In fact, benchmarks like Fed Funds have very little impact on the credit markets compared with other factors. The folks at Fed Dashboard , for example, note: “The Federal Open Market Committee (FOMC) expects their interest rate decisions to change the economy because they expect the Effective Federal Funds (EFF) rate implemented at a trading desk at the New York Federal Reserve Bank to consistently cascade across credit classes from Treasury Bills to business and consumer borrowing.” But they warn that the Fed Funds rate “has not been consistently cascading through credit rates for decades, reducing the benefit to borrowers.” Of course, folks at the Fed do not seem to have much time for thinking about banking matters much less the functioning of the credit markets. One senior DC counsel told a group last week that Fed Chair Janet Yellen is “not terribly interested in bank supervision” and instead is focused on how monetary policy affects “working households.” The same observer says that the Board of Governors is likely “to be forced to do something about the Wells Fargo & Co (NYSE:WFC) board.” But apart from the intricacies of monetary policy, there is hope on the horizon for financials as President Trump changes the composition of the Federal Reserve Board and the leadership of other federal regulatory agencies. The Fed Board will remain at just four governors next month with the departure of Stanley Fisher and last week’s Senate confirmation of Randall Quarles as vice chair for bank supervision. Regardless of whether the Trump Administration makes any additional appointments to the Fed or other agencies, over the next year and more we look for a roll-back of regulations put in place since 2008. This is a primary reason why we believe that Chair Yellen is ultimately headed back to the private sector. Even before Quarles was approved, banking agencies were exercising their rather considerable discretion in a number of areas such as capital charges on commercial real estate and the Volcker Rule. The massive regulatory friction accumulated in the banking system and also in consumer facing nonbanks over the past eight years is being reduced. “The trend is clearly going the other way,” a veteran bank lobbyist opined last week. “Statutory provisions can largely be eviscerated by agency interpretation.” Indeed, despite the fact that the Trump Administration has not appointed many agency heads with responsibility for financial services, the fact is that the Treasury under Secretary Steven Mnuchin is driving the bus on reform and is making a lot of regulatory changes that are already in process. Deregulation is a far more important factor for financials than the illusory prospect of higher interest rates. Overall, the trend in terms of reduced regulatory burden on both banks and nonbanks is clearly positive and may contribute positively to earnings and economic growth next year. As we discussed last week , loan yields for the largest US banks are not that strong and volumes are modest, so with Q3 ’17 earnings we don’t look for many positive surprises on the asset side from the large banks as a group. Several names including Goldman Sachs (NYSE:GS) have warned on sales and trading revenues. We expect to see some weakness on the mortgage banking line due to weak volumes, frothy collateral pricing and small down marks on mortgage servicing rights (MSRs). The rebound of yields on the 10-year Treasury in September, however, may be helpful in this regard. While Chair Yellen may be able to justify rate increases to at least two of the other members of the FOMC, the continuance of QE in Europe and Japan promises to maintain downward pressure on market rates and credit spreads. There is simply not enough demand for credit from the real economy to satiate the need for assets from the financial sector. The world of large banks, institutional investors and insurers, for example, is basically Jurassic Park, where large carnivores compete for limited food in a shrinking marketplace. For example, sales of all types of asset securitizations by US banks are down 10% year-over year, an illustration of the drought of duration that exists in global markets and has been ongoing for years. Sales of securitizations (which is 90% residential mortgages) was once a multi-billion dollar per year proposition for US banks in terms of revenue, but now is just pennies. Table 1 below shows assets securitized and sold for all US banks through Q2 2017. Source: FDIC A big part of the reason for the decline in asset securitization volumes since 2008 is the Dodd-Frank law, but also is due to regulation and the resulting migration of US banks away from residential mortgage lending and also a decline in volumes. As in the case of Europe, public debt issuance in the US since 2008 has seen a big increase, mostly via borrowing by the US Treasury. Debt issuance by corporations, which have tended to borrow to fund stock repurchase programs, has also surged. But neither of these factors is actually bullish for economic growth or bank earnings. Zero rates and QE a la Yellen, Draghi and Abe is not about growth so much as it is about subsidizing debtors, especially governments and other public obligors who are beyond the point of recovery in terms of ability to repay debt. This financialization of the US economy is perhaps the single biggest driver behind the bull market in US equities and bonds, but has done little for income or employment growth. Chart 1 below show total US debt issuance in most asset classes. Source: SIFMA The regulatory pendulum in the US is clearly swinging towards ease and that is good for inflated expenses in most banks and consumer facing non-bank financials. Overall, though, the prospect is for bank earnings and revenue growth to stay “lower for longer,” even as the actions of global central banks drive up prices in many asset classes. Until global central banks end asset purchases and allow credit spreads to revert to something closer to the norm, it is going to be very hard for banks to generate any real earnings growth -- particularly if the Fed’s obsessive increases in short-term benchmark rates result in a flat Treasury yield curve. An end to QE also implies a significant increase in credit losses for US banks, an eventuality that will not be a problem given robust reserve and capital levels. But the wild card for global financials is whether the suppression of credit spreads by the Fed and other central banks has caused the formation of another hidden hot spot of risk that is currently hidden from investor scrutiny. And for our money, that hot spot of risk may well be in Europe, where many banks are lingering on the edge of insolvency and politicians are absolutely frozen in place. In that bad idea called the European Union, the tragicomedy known as banking lurches from one absurdity to the next as the community struggles with trillions of euros in bad debts. Last week, the European Central Bank (ECB) “launched a fresh push,” reports the Financial Times , to get European banks to take reserves on bad loans. The only problem is that the new regulation applies only to loans that go bad after the start of 2018, leaving a decade of accumulated bad debts untouched. Under current international accounting rules, EU banks can essentially ignore (and accrue interest) on bad loans. This makes published financials for EU banks completely useless for investors and credit rating agencies. More, just as “quantitative easing” in the US has not particularly helped either the resolution of bad loans or new lending, in the EU the opportunity created by ECB chief Mario Draghi’s efforts has been largely wasted. More public sector debt has been incurred and the banks – which admit to some €850 billion (6%) in non-performing loans – are essentially insolvent as a group. The FT’s Lex column notes with considerable understatement that EU banks “may be treading water” and that, when off-balance sheet exposures and derivatives are considered, EU banks are running at about 25:1 or more leverage. This compares favorably to large US banks such as GS, JPMorganChase (NYSE:JPM) and Citigroup (NYSE:C), but is far higher than all US banks as a group. It is some measure of the extremis in which Europe’s banks now operate that the former Italian premier, Matteo Renzi, almost immediately attacked Draghi’s actions as possibly causing a decline in lending to small and medium size enterprises in Italy if implemented. “Some European officials in the banking sector ignore that their duty is to AVOID credit crises, not CREATE them,” he Tweeted on Thursday, borrowing from the communication style of President Donald Trump. Later Renzi added: “If these rules pass, credit to small businesses will be impossible. We are making the same mistakes as 2013.” In Europe the “mistake” leading up to 2013 was when the ECB forced the tiny nation of Cyprus into a forced banking liquidation. Lacking a mechanism like the FDIC in the US to resolve insolvent banks, the Europeans instead destroyed the Cypriot banks and pushed all of Europe to the verge of a financial collapse. Since then, the EU and its members states have subsidized failing banks, most notably in Italy. And the ECB under Draghi has doubled down on QE and negative interest rates to keep the prospect of further financial contagion at bay. So as earnings season begins in earnest in the US this week, there are two big risks facing investors who hold exposure to US financials. First, there is still little in the way of revenue growth to support rising valuations. Remember, don’t fight the Fed (and ECB and Bank of Japan). Some of the better performers like Bank of the Ozarks (NASDAQ:OZRK) are up double digits this year, confirming our earlier warning about short positions in this national C&I lender. Even GS has managed to show some upside of late even though it may have some of the more disappointing results for this quarter. But at 1.9x book, OZRK and many other names are fully valued using any sort of Warren Buffett measure of future cash returns. Second, the continued incapacity of EU leaders to deal with the festering problems inside Europe’s banks creates a very dangerous situation for investors. The media and their enablers in the Sell Side chorus have been touting the prospects of Europe for many months, but the reality is very different indeed. Europe is drowning in debt and there are a number of large EU banks that are demonstrably insolvent. The use of derivatives and off-balance sheet financing to “double down” and save some of the bigger zombie banks is bound to end in tears. And such machinations increase the chances for a “surprise” event, which as we all know is the precursor to systemic contagion. With low levels of visible volatility in evidence, we can only note some very big contrarian options trades in the VIX of late that remind us of 1992 when George Soros broke the pound sterling. Have a great week. ------------------------------- This Tuesday The Institutional Risk Analyst’s Chris Whalen will appear at American Enterprise Institute in Washington, D.C., to talk about “How has a decade of extreme monetary policy changed the banking system.” With Q3 earnings looming next week, a discussion of the Fed’s structural distortion of banks and banking seems most appropriate. Click here to see our presentation.